What are futures and options?

Posted by aarav badhe on February 15th, 2020

A derivative is an instrument that derives its value from an underlying asset like a stock or a commodity, for example gold futures derive their price from the value of gold. Equity derivatives are a highly popular product.

There are different types of derivative products in India:

• Forwards
• Futures
• Options
• Swaps

Out of these, futures and options are the most popular contracts. It is important to know what are futures and options if you plan to make derivative trades.

What are futures contracts?

A futures contract is an agreement between two parties to buy or sell a particular asset at a price on a particular date. If you’re the buyer in this type of contract, you are taking a long position whereas if you’re a seller then you are taking a short position.

A futures contract can be for any underlying asset i.e. stock, commodity, index, currency. The price of the futures contract depends on the spot price of the underlying asset and future projections. For example, a nickel future may currently be priced at Rs. 1010.20 for February expiry.

If a futures contract is held till expiry, then the holder must honour the agreement. If the agreement is to buy shares of company A at Rs. 500, then the holder of the contract will have to purchase shares. The seller will have to sell shares even if he doesn’t own them. Another way to settle futures contract is by settling the difference between the current market price or the spot price and the futures price or the agreement price.

What are options?

Options are derivative contracts where the option holder has a right but not an obligation to either buy or sell the underlying mentioned in the contract. For example, if the option holder holds an option to buy shares of Company A at Rs. 500 and the current market price is Rs. 460, he can decide to let the option lapse and not honour the agreement. The derivative contract gives him the option to do that.

Since the contract has a chance of lapsing, the option seller gets compensated in the form of an option premium. This premium depends on the underlying asset, the period of the option and whether it is a call or put option. The seller of an option takes on maximum risk in case he must honour the option. The buyer’s risk is restricted to the option premium that is paid on the option.

How to trade in futures and options:

It is important to understand what is F&O trading if you want to get into the market. Both futures and options can be settled by taking the opposite position. For example, if you buy crude oil futures, you can exit the trade by selling crude oil futures whenever you have made profits on it. Similarly, you can settle options. In case of index options, the gain or loss is marked to market or gets impacted in the margin account every day. When you have made profits on the trade, you can reverse the trade and exit it.

One important concept to learn is that of margin. You do not need to put up the entire capital for a derivative trade. You can leverage the margin by making trades much higher than the margin amount. Every broker has a margin calculator which you can use before you want to start F&O trading.

Once you find out the margin amount from the F&O margin calculator, you can deposit those funds with your broker and begin making trades